Business Valuation

Business Valuation

Seminar 3:

Q5-12 (pg 180):

12. IAS 1 recognizes the need for full disclosure of the components of reported NI. Explain why full disclosure of net income components is important if investors are to properly interpret the implications of current reported net income for future firm performance. What is classification shifting? Why does classification shifting makes it more difficult for investors to predict future firm performance from current reported net income? How could the problem of classification shifting be reduced?

• Earnings persistence: high persistent items vs. low persistent items in earnings
• Classification shifting: the deliberate misclassification of items within the income statement to overstate the ‘core earnings’. This usually happens in the allocation of fixed costs between core expenses and special items.
• Investors may overestimate earnings persistence
• This problem can be reduced by separate reporting of the direct and allocated costs of low persistent cost items.

Q5-20 (pg 184-185):

1. Not copied yet cause its numerical
2. What was the abnormal return on Best Buy’s stock on September 13, 2005? Is this return consistent with securities market efficiency? Explain why or why not.

Sep 13 ’05: A decline in share price of 10.2% → Actual Rjt= -0.1020

Abnormal Return = Actual Rjt – E(Rjt)= -0.1030-(-0.0437)= -0.0583

The negative AR suggests that the market have interpreted the new info. On Sep 13, 2005 as bad news.

Explanation for the bad news interpretation:

• Actual EPS of 2005Q2 EPS (=37cents) < Market Expectation (=38cents)
• Mgmt forecast of 2005Q3 EPS (=28-2 cents) < Market expectation (=34cents)
• Expectation of negative effects of hurricane Katrina on the firm’s near-term profitability
• Investors were worried about the effects of high energy prices on consumer spending

However, the firm’s announcement also contained some good news:

• Sales and gross profits increase
• New Store openings
• Reiteration of expected 26% future earnings growth
• 2005Q2 EPS (37 cents) were up considerably, from 26 cents for 2004Q2.

The fall in stock price seems consistent with market efficiency if we accept that the impact of the bad news outweighed that of the good news.

1. Evaluate (in words only-no calculations required) the persistence of the bad news (i.e. the increase from 26 cents per share to 37 cents per share) in Best Buy’s second quarter 2005 earnings.

• Negative effects of hurricane Katrina → Low persistence of the effects
• Mgmt concern about high gasoline prices → Low persistence of earnings
• Sales and gross profits increases, particularly same-store sales → high persistence
• Increase in the gross profit ratio → high persistence
• Opening of additional stores → high persistence
• Reiteration of expected 26% future earnings growth from continuing operations → high persistence

A reasonable conclusion is that the earnings increase is of medium-high persistence

Seminar 5:

Q 7-2 (p298):

2. A biotech company

1. How is the 20% of proceeds allocated to the service obligation viewed under historical cost accounting? How would the obligation be viewed under a measurement approach?

• HC accounting: the income statement is the primary financial statement

• NI for a period represents the difference between revenue recognized during the period & the expenses incurred to earn the revenues
• Revenue received in advance → deferred on the BS to future periods & matched with expenses

• Measurement approach: the BS assumes greater importance

• NI explain changes in the current values of A&L during the period
• Revenue received in advance → measure a liability at current value & record a decline in revenue in this value during the period

b. Suggest one or more ways to determine the amount the firm would rationally pay to be relieved of the obligation

• Discounted PV of the costs expected to meet its contractual liability for updates and virus protection
• If there is a market for the required services

• If MV of the services< the firm’s cost estimate, the obligation would be valued at MV, because MV is the amount that the firm would rationally pay to be relieved of the obligation.

• The liability would be remeasured at each period end over the 3 years to show the expected cash outflows remaining.

1. Compare the relevance and reliability of your suggested approach(es) with the matching approach of writing the obligation off over 3 years.

• Relevance:

Measurement approach (MSRM) > Matching approach (MTCH)

-MSRM measures expected future CFs

-Under HC accounting using MTCH, the BS measure of the obligation does not measure future CFs, but rather the portion of the deferred revenue remaining to be allocated to future periods